Thursday, August 16, 2012

Iraq's Rise To No. 2 Oil Producer In OPEC Is Bad News For World

Iraq has finally overtaken Iran as the second largest oil producer in OPEC according to the InternationalEnergy Agency. Baghdad chalked up 3mb/d production compared to 2.9mb/d from Tehran. For some, that’s cause for celebration – ‘proving’ that international sanctions against Iran are ‘working’ – but it merely highlights the profound supply side problems afflicting the oil world. Bad news all round.

The idea that Iraq, now the second largest producer in OPEC, could be relied upon to provide consistent (let alone) excess supplies, flies in the face of all the political problems afflicting the country. Its main output gains have come in Kurdistan, a region that the central Shia government in Iraq refutes as a self-standing oil producing region. The dictum was very clear after Saddam fell; those who do business in Kurdistan will be barred from far bigger fields in the centre and South of the country. Ballpark numbers certainly backed it up. Baghdad sits on 143bn barrels of ‘proven’ oil reserves, compared to 40bn barrels in Kurdistan. For a time, it was a message that most IOCs were happy to heed. The likes of Exxon, BP, Lukoil and Shell signed very unattractive service contract agreements (i.e. hired help), with a view to securing proper production sharing agreements with Baghdad down the line. The problem is that Baghdad has never worked out what’s good for them; decent contracts have never been put on the table to entice IOCs (or national counterparts) to see Iraq as a serious proposition. Fields haven’t been developed. New infrastructure hasn’t been built.

That’s exactly why the biggest players, including Exxon, Chevron, and Total have called Baghdad’s bluff by signing bilateral deals with Kurdistan as the more credible (if modest) output option. Unless Iraq blinks first to revise contractual terms, don’t expect IOC investment anytime soon. Baghdad might take their chances with the Chinese, (if Beijing happens to still be interested). Russia might invest when asked, but they’ll make sure new fields only come online at times of their choosing for global fundamentals. Alas, far from blinking, Baghdad has kept their eyes wide shut. Although it didn’t chuck Exxon out of West Quarna plays, it barred them from their latest licensing rounds, and indeed Chevron for their ‘Erbil betrayals’. Baghdad will hit its ‘12mb/d’ production targets by 2017, with or without international help – or so the story goes. The snag isn’t just that Kurdistan provides IOCs with the perfect hedge to put pressure on Baghdad, but that Iraq hasn’t understood the unfolding contours of the new energy world. Ten years ago, the greatest risk for IOCs wasn’t operating in high risk, uncertain return markets, but not having access to prospective elephant fields in the first place. It was ‘follow the resources, or die’.

The global unconventional explosion has totally re-written this analysis. If you aren’t willing to offer decent terms and decent conditions, investment won’t come. International players can pick and choose jurisdictions for the best returns. You’re as likely to find a herd of elephants in the US Mid-West these days as you are in a highly explosive Middle East, which, if anything, provides the real kicker for Iraq here: Not only is Baghdad offering poor fiscal terms on new concessions (without any serious legal structure), it’s doing so in an increasingly large security vacuum. Since the US upped-sticks, local grievances have been sharpened without a common enemy. 19% unemployment and chronically high levels of absolute poverty afflicting the population don’t help. But it’s sectarian schisms that remain the most divisive fault lines rather than rich vs. poor in Iraq. Oil sits at the heart of this debate.

However you spin things, IOCs are bankrolling Kurdish succession in the North thanks to enhanced oil receipts (Turkey could obviously do without such developments), while Sunni politicians (let alone insurgency groups) have never come to terms with Shia power, embodied by the al-Maliki central government. Something will eventually have to give in Iraq on how state formation does (or doesn’t) play out, with oil providing the underlying formula for who gets what, where, and when. That’s before you ‘price in’ external meddling from neighbouring Iran, a nation that’s more than happy to stir the Shia pot to progress its economic and political interests in the region. Clipping Iraqi oil production is the perfect way of doing that. It hardly went unnoticed in Tehran that Iraq made as much cash ($22-24bn) in the last quarter. That’s not been the order of things since the 1990 Gulf War; Iran will work hard to keep it that way.

Put all that together, and Iraq will struggle to nudge output towards 4mb/d over the next few years, let alone hitting 5, 6, or 7mb/d over the next decade. As for 12mb/d production targets by 2017 as a the new ‘swing producer’, forget it. Iraq has squeezed out all it can from its older fields; any further gains will be attritional, at best. The upshot is that we’re left with the same oil market equation we’ve had for decades: Saudi Arabia and Russia are simply too big to fail. No one, least of all Iraq is going to change that anytime soon when it rejoins OPEC quotas in 2014. It’s therefore all the more disturbing that the IEA are pinning their main global supply growth hopes on Iraq over the next decade.

But let’s be generous and assume Iraq prevails against all the odds; you then have to beg the serious question: Would enhanced oil royalties from 7mb/d oil production be the catalyst to hold Iraq together from sharing the spoils, or would it rip the country apart? In a winner takes all system between its constituent parts, my bet would be on the latter. The more Iraq gets it oil ‘right’, the more likely things will end in spectacular (and very crude) failure…